Asset prices fall if investors’ liquidity preference rises or if their liquidity falls (ie, if investors need the money or want to have more cash in their portfolios). Liquidity depends on central banks; they can create it or soak it up. The US Federal Reserve seems unlikely to reduce liquidity unless inflation picks up, but is likely to stop creating it in October. Therefore, one way in which asset prices will fall is a rise in inflation or pre-emptive action by the Fed to stop it.

When the Fed creates liquidity, it takes a larger rise in liquidity preference than before to hit asset prices. The Fed is thus in the process of increasing the market’s sensitivity to rises in liquidity preference and, as small changes are the normal response of investors to new information, the volatility of the market is therefore likely to rise. In the absence of increased interest rates, large changes in liquidity preference, however, are likely to depend on falling profits. Read more

After a period when consensus ruled, economists are as much at odds today as they were in the 1980s, and policies can alter sharply when those in charge change. Quantitative easing is today the main bone of contention among policy makers and economists.  Read more

According to an article in The Economist on August 2, “economists trying to explain the feeble pace of America’s recovery regularly blame deleveraging”. This raises two questions: can the US recovery sensibly be described as feeble and, if it can, is deleveraging to blame? Read more

In a comment on my recent blog regarding the equity risk premium, “Le gun” asked for a guide to making long-term investment decisions and I promised to try.

In 2009 TengTeng Xu and I addressed this issue in a paper called “Investment and Spending Strategies for Endowments”. We were specific because the need for income and the investor’s time horizon should both be taken into account when deciding on a sensible policy for individual investors. We considered the use of only three asset classes: equities, long-dated bonds and short-term deposits (cash). We did not include property because we were unable to find suitable long-term data and dismissed commodities, including gold, as combining poor returns with high volatility. With regard to the possible portfolios, we came to several conclusions which I will adapt here for all long-term investors, rather than just endowments. Read more

I assume and hope that Scotland will vote to maintain the union on September 18. I am, however, sceptical of the barrage of claims that Scotland will either be necessarily better or worse off if a majority vote “Yes”.

Countries have grown at hugely different rates in the past. Chart one (below) shows the relative growth rates in terms of gross domestic product per head of Ghana and South Korea. In 1950, when the data series starts, the standard of living of Ghanians was 30 per cent higher than those in South Korea, but the latter were ahead by 1965 and, by 2008, when the data series ends, had living standards twelve times higher.

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The gross domestic product data for the second quarter of 2014 showed that the US economy bounced back strongly, and with enough vim to justify the view that its first quarter weakness was largely due to bad weather.

However, the productivity figures provided another bad surprise. In the first quarter GDP per hour worked fell, and it would therefore have been reasonable to expect it to improve with the sharp recovery shown in the second quarter. In fact, there was another fall.

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Ed Balls, who has a high chance of being the UK’s next chancellor of the exchequer, has announced that the opposition Labour party is “examining the case for introducing an allowance for corporate equity, to redress the systemic bias in favour of debt finance”. This would be very sensible, but it needs to be done sensibly.

Allowing interest as a deduction before calculating the profit on which corporation tax should be paid encourages excessive debt, buybacks of equity in preference to long-term investment and debt-financed takeovers. The views of economists on its undesirability are one of the few instances on which they are almost all agreed. It is one of the rare exceptions to the old rule that “n economists = n+1 opinions”. Read more

The UK has a seriously unbalanced economy, with little spare capacity and a slow trend rate of growth. To correct its imbalances, the current account deficit and the cash flow surpluses of the corporate sector need to fall. This would permit a fall in the fiscal deficit, but requires a fall in the real exchange rate and in the share of consumption in gross domestic product.

The fall in the trend rate of economic growth comes from a combination of a slower growth in the population of working age and a drop in productivityRead more

In some of my more gamesome moments I have challenged my students to produce an article about the equity risk premium, which made a useful contribution to our understanding of the way financial markets work. So far the challenge has not been met. This may reflect the modesty and good manners of those I teach but also, I hope and believe, the fact they are too sensible to wish to defend the way this often ill-defined and generally useless concept has been habitually discussed. In practice, comments on the ERP seem to me to have been a source of confusion and error rather than illumination.

The ERP can be defined in at least two ways. One is the historic difference between the returns on bonds and equities and another is the expected difference in these returns. Alternatively, the “risk-free rate” can be used in place of bonds. Read more

A few weeks ago, I promised to write about claims that the stock market could be valued by comparing earnings yields to bond yields. This approach is sometimes called the “Fed model”. This was fashionable in the 1990s and seems to have some followers even today. It is not only nonsense but is the most egregious piece of “data mining” that I have encountered in the 60-plus years I have been studying financial marketsRead more